Can't help, won't help: why rate cuts won't make our banks lend more

Apologies if you are eating breakfast, but just imagine, for a moment, that
you are the chief executive of a British bank.

By Tracy Corrigan

6:00PM GMT 08 Jan 2009

Capital is in short supply, yet you are expected to hold more of it than prior to the financial crisis. The value of your assets is still falling. When you are, in due course, forced to write down these losses, you will be required to stump up even more capital.

So what do you do? There are two obvious strategies. First, hold on to as much capital as you can, by lending as little new money as possible, and try to grab some of it back by recalling loans whenever companies breach the terms of their borrowing; secondly, make as much money as you can when you do lend, so that you can rebuild a cushion to help you cope when you are hit by the next wave of writedowns.

Of course, you can't really come clean about what you are doing, because you are already in the doghouse for having helped drag the economy into recession. Also, you have more than likely just received a slug of taxpayers' money, and part of the deal you made with the Government was that in exchange for that help you would make sure that you carried on lending to companies and consumers, much as before.

The point is not that bankers are behaving badly, though they do seem to be doing the exact opposite of what the Government wants and damaging the economy in the process. The point is that they are behaving rationally, from their own narrow perspective. For anyone running a business in hard times, self-preservation becomes the top priority. It is naive to expect otherwise.

The banks are in survival mode and yesterday's half-point cut in interest rates to an all-time low of 1.5pc will not change that.

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Will the cut help businesses which have run into difficulty even though interest rates are already pretty low? There are several reasons why companies can find themselves facing the financial firing squad. Firstly, they may have breached banking covenants, as a result of a decline in the business's performance. Lower interest rates may make this less likely to happen, but if the company's revenues have plummeted, further rate reductions from already low levels are unlikely to make much difference. Secondly, companies may need to refinance their debt, but find it impossible to persuade their banks to hand over the cash, even if they have previously serviced their interest payments satisfactorily. In this case, lower interest rates are not the issue. Finally, the value of the business may have collapsed so that it is worth substantially less than its debt, in which case the size of the debt, not the level of rates, is the main problem.

There is one silver lining for businesses: if a company breaches its covenants, but is still able to service its debt, though not to repay it in full, banks have a vested interest in allowing it to try to trade its way out of the mess. In these cases, covenants are likely to be renegotiated. But in sorting out which companies to back and which to let sink, the banks are thinking about their balance sheets, not the broader needs of the economy.

As for those banks which didn't need to raise additional capital – notably HSBC – any additional lending is unlikely to bridge the gap left by the disappeared and the disabled.

Does this mean that the Government's injection of £37bn of capital to bail out Royal Bank of Scotland, Lloyds TSB and HBOS was a failure? Since it didn't get banks lending again, it hardly ranks as an unqualified success. But that is probably the wrong measure, even though it is the one stated by the Government and accepted by the banks. The bail-out prevented a total collapse of the financial system, which was probably only days away. Compared with the state the economy would be in if that had happened, the current state of affairs is a bed of roses. As failures go, the recapitalisation was pretty successful.

However, while the financial system has not collapsed and lower interest rates are helping some businesses and consumers, banks are still part of the problem. They have strong incentives to hoard cash – not least, that it makes sense to repay preference shares from the Government that are costing them dearly, before cranking up lending again. There are several possible solutions, including state lending to companies in tandem with banks and the creation of a "toxic" government-backed bank to buy up distressed assets.

Without some sort of additional help, it seems likely that some banks will need more capital – RBS, already 60pc state-owned, does not look far from nationalisation. After all, the £37bn injected so far is roughly half some City estimates of the amount needed to recapitalise the system – and that number must be rising as asset prices fall.